Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Friday, September 21, 2012

These Clowns May Actually Have a Point.

Every investor has certain
criteria that signal when to exit a position. For some it is when the
investment reaches fair value thus limiting further upside potential. For
others it is periodic portfolio rebalancing. Meeting a particular technical
threshold causes investors of that ilk to head for the exits. And famously, it
is when the buzz of a particular hot stock or strategy becomes deafening,
discussed endlessly in bars, on subway platforms and in barbershops, where the
conversation usually centers on mind-numbing sports babble. I am reminded of
the latter illustration when surfing the thousand channels in my cable package
(none of which are worth watching) and noticing that every commercial not
promoting prescription drugs is some guy in a cheap suit hawking gold as an
investment. My first thought upon seeing these commercials is “didn’t I buy a
set of knives off this dude last year?” and the second one is “dear God, he’s
actually making some sense.” This is the same feeling one gets when watching
Ron Paul’s libertarian rants and finding himself nodding in agreement. Aside
from the direst of the apocalyptic scenarios underlying their rationale for
gold investment, many of the central tenets of the gold bugs’ arguments prove
timely in this period of easy money and the weakening position of other
safe-haven assets. Leaving the possible attractiveness of gold as an investment
to the infomercial class, here we will delve into what the recent rally tells
us about the economy, namely inflation prospects, and how current policy is
distorting financial markets, including those for real assets (i.e. those that should hold value in inflationary
periods).

Some Background

When cutting through all the hubbub
surrounding gold, one should not lose sight of the fact that it iim onrsome sense a Point.more attention to
those gold commercials during halftime of this weekend' unsustainable U.S.
fiscal pos essentially a hunk of naturally occurring metal. Its value is
derived from the fact that it’s a very pretty and shiny hunk of naturally
occurring metal. What’s more, it is quite scarce. It is estimated that since the
time our ancestors first grabbed a pick-axe, man has mined roughly 171,000 tons
of the stuff. That amount could easily fit into a single Wal-Mart Supercenter. The
combination of allure and scarcity has made gold a standard unit of trade
throughout history. Fast forward to the days of modern currencies and
sophisticated investments, the rationale for storing one’s wealth in gold
becomes more complex. Commerce is eagerly conducted in currencies no longer
backed by a specific amount of gold, and as an investment, gold just sits
there, yielding nothing. Not only does it not spin off cash like a bond or dividend-paying
stock, but one, if smart, has got to pay a well-armed custodian to keep it
under lock and key. Over the long-term gold’s appreciation is laughable. In
1900 gold traded for $20.67 an ounce, or $503 in current terms. As recently as
2006, the price of gold was below $600. A hundred bucks of appreciation in a
century? Sign me up.

But in the short-run, gold can
see massive appreciation. Of course we are speaking of periods of economic
tumult, inflation and a lack of trust other investment instruments. Ring
familiar? The prime culprit, according to Dr. Paul and his acolytes, is fiat
money. As stated earlier, gold is pretty hard to extract, thus lending to it
the qualities that make it a stable medium of trade. By contrast, in the era of
fiat money, central banks just need to flip on the printing press and voila,
everyone is swimming cash. Case in point: at the current spot price ($1,776 /
troy oz.) all the gold in the world would have a value of $9.76 trillion.
According to the World Gold Council, the supply of broad money globally is
approximately $60 trillion. That’s a lot of paper with pictures of old men. Given
the rupture in the compact between authorities and citizens that the bills in
their wallets won’t be cavalierly debased, it is no surprise that people have
begun looking for alternative stores of wealth.

Demand Revolution

As with other commodities, gold
has its own supply and demand dynamics. It should come as no surprise that the
largest source of gold demand is from the jewelry industry, a market which is
dominated by Indian buyers, who account for about one-third of gold jewelry
demand. As recently as five year ago, jewelry still accounted for over 75% of
total gold demand. Since then its share has dropped to 43%.

Driving the shift is the desire
for safe-haven investments during the financial crisis along with a
proliferation of new vehicles such as ETFs, which have increased accessibility.
As seen below, investor demand has risen from 12% to 38% over the past decade. High
prices, consequently, have dramatically curtained jewelry sales, especially in
poorer nations such as India.

Why the Gold Rally Now?

A central premise for owning gold
is its history of holding value in periods in which the purchasing power of
paper currency, namely the U.S. dollar, weakens. But inflation across the
developed world remains muted. The IMF projects that inflation in advanced
economies will remain below 2% for the next five years as global growth remains
lukewarm. Even in emerging markets the rate of inflation is declining
(disinflation), further echoing growth headwinds.

Rather than red-hot economic
expansion spurring inflation, investors are worried the historic monetary
easing programs undertaken by central banks, especially the Fed, will debase major
currencies. Although weak growth may be keeping a lid on inflation today, the
torrent of liquidity will ultimately find a home and possibly cause asset
bubbles in the process. Often gold rises with industrial commodities like crude
and base metals as the same high growth rates that increase demand for those
products spurs inflation (for which gold is a useful hedge). For the near
future, the risk is that yield-seeking investors, riding the wave of QE3, will
seek commodities exposure and in turn drive up the prices for those industrial
inputs, fueling inflation even in a period of tepid real economy demand.

Woe is the Dollar

Gold is now sought not only in
anticipation of such inflationary pressure, but also due to investors recoiling
from holding USD-denominated financial assets in this period of easy money.
Further diminishing the dollar’s outlook is the reality that central banks are
famous for not reacting in time to mitigate incipient inflation, an outlook
possibly priced into a recent jump in TIPS implied inflation (above). There is
also the grim U.S. fiscal position making the allure of inflating away the
country’s massive external liabilities via a weaker greenback a plausible
scenario. Sorry China, but thanks anyway for purchasing the trillion-plus of
U.S. debt.

For reasons explained above, the
dollar has a negative relationship with gold. When the value of the world’s
dominant currency rises, the desire to hold gold as a hedge recedes. This relationship
has grown stronger over 2012, especially during the summer when weak jobs data
created the expectation that the Fed would once again resort to extraordinary
measures, despite how bare its cupboard was. In certain periods of market
tumult, gold and the dollar can move in lock step as investors flock to safe
havens such as U.S. Treasuries and bullion. Not to downplay the potential
repercussions of a Eurozone meltdown on financial markets (the S&P 500 is
nearing a five-year high so no worries there….for now), the rise of gold in the
absence of a crisis (or inflation) can be best seen as a lack of faith in the
forward path of the greenback given the dubious monetary and fiscal policies
emanating from the Beltway.

Speaking of the Euro…

If the rise of gold vis-à-vis a
particular currency is considered a bad harbinger, then the Euro is in real
trouble. This month gold hit a record high in Euro terms and has risen 163%
over the past five years against the common currency. This period not only
covers the global financial crisis, but also the three-year old Eurozone crisis
that has been characterized by a steady retreat by the ECB from its stable
money mandate and its willingness to overlook multiple dictates, such as those
governing the credit quality of collateral and the purchases of sovereign debt.

Whereas the Euro has endured a
slow bleed over the past year in gold terms, the metal’s recent spike against
the dollar….putting it only 6.3% below its record high….has been a summertime
phenomenon. Since May, Gold in USD terms has gained 14%, compared to a 7%
against the Euro, the cause of which, again, was the market’s (correct)
assumption that the Fed would be forced to act in the face of chronic 8%-plus
unemployment.

And in the End

Gold’s steady rise can be seen
through two lenses, neither of which is rosy. Either it is another asset-bubble
induced by the Fed’s loose monetary policy. Eventually the folly of putting a
hunk of one’s net worth in a rock that yields nothing will be recognized and
investors will exit the trade. But maybe better a gold bubble than once again
building endless subdivisions of cheap houses. Or investor demand for gold can
be seen as a prudent move to hedge against the continued downward path of the
dollar most recently fueled by three rounds of quantitative easing (slick
parlance for printing money).Should the
Fed be able to sop up these liquidity injections in time to nip inflation
(either caused by real growth or rising commodities prices….yet another
speculative bubble caused by the Fed) in the bud, then this may all end well.
And perhaps policy makers will get serious about tackling the unsustainable
U.S. fiscal position and thus take away that USD headwind. If these two steps
do not happen…and that’s a big if….one
may want to pay a bit more attention to those gold commercials during halftime
of this weekend’s football games.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.